Isn’t It a Bit Too Late for Stock Market Cheerleaders to be Coming Out?

When S&P 500 had lost more than a tenth of its value in the first week of February, Wall Street analysts dismissed it as a minor blip in an otherwise ‘entitled’ eternal rally that’ll supposedly make us all uber-rich. The truth is that at the end of the first week of Feb, little over half of S&P 500 constituents had reported 4Q17 earnings, with S&P 500 earnings (‘as reported’) suggesting just under 11 percent growth, making this the fourth straight quarter of earnings deceleration, with 3 to 4 percent earnings growth in the past quarter attributable to stock buybacks alone. On ‘as reported’ earnings basis, the index began Feb at approximately 21x C2018E earnings.

‘As reported’ C2018E Street estimates were pointing to +33% earnings growth! With 4Q17 operating margins at the highest levels we have seen in well over a decade, and the American Dollar unlikely to be a tailwind, it is remarkable that Street could somehow project more than 30 percent earnings growth for C2018E in an otherwise decelerating earnings environment. Add in the fact that we have seen a largely uninterrupted rally over the past few years and to call a selloff at these valuations a ‘minor blip’ is borderline ridiculous. We have maintained that the key risks to global markets today come from valuations and estimates for heady earnings growth on already elevated bases. Much doesn’t need to go wrong in such situations for investors to lose. It feels like investors are so busy looking at the relatively clear road ahead, that they are not mindful of the fact that the dashboard might be showing very little gas in the tank.

Tale of two worlds. Currently in India, we have Nifty 50 on one side and everything else on the other end of the ‘froth’ spectrum. While we view Nifty’s valuations as a bit stretched, small and midcap valuations (as a universe) are unequivocally rich. It seems like institutional participants are finally jumping on the earnings growth bandwagon and stories are being created around a bullish narrative that has already catapulted a large part of this market into orbit. From where we stand, while mid/high-teen earnings growth can support Nifty’s valuations, one would need to see an extended run of clean 20%+ broad-based growth to support current valuations in the small and midcap universe. With profitability across most industries at or near their peaks, and material costs beginning to weigh on most names, it is hard to see how Nifty 50 (ex-financials) can clock 20%+ earnings growth (Street consensus as at Dec end 2017) in FY19E. While small and midcap earnings are likely to be a bit better, most stocks are already pricing in unrealistic growth expectations. Over the course of the next couple of quarters, we expect Nifty’s FY19E (Mar) expectations (ex-financials) to likely get cut towards at least mid-teens from 20%+.

F3Q (Dec) earnings were mediocre for Nifty. In F3Q (Dec), Nifty 50 (ex-financials) posted approximately 9.5 percent earnings growth when comping a weak demonetization-hit quarter from last year. Even this headline performance was replete with drivers that aren’t reflective of any broad-based turnaround - in names such as Asian Paints, almost entire earnings growth was attributed to spending cutbacks and process changes even as volume growth was mediocre. Excluding the windfall from the IUC fee cut, Reliance Industries’ F3Q earnings growth would have been 15 percent (vs. the headline 25 percent growth). Overall, 70 percent of Nifty 50 constituents (ex-financials) missed their estimates and that’s when we count names like Infosys among the ones that beat consensus, where the beat would have been a miss if it hadn’t been for reversal of prior tax provisions.

In a quarter that was supposed to deliver clean and solid earnings growth off of a low base, Nifty’s numbers were unequivocally poor. Given that FY19E wouldn’t have as much of a poor comparison to benefit from, given that weakness in the informal economy is real, given that materials costs are a clear headwind almost across the board, and given that (excluding Commodities and select Industrials) most industries are already at or close to record high margins, it was puzzling to identify the next leg of growth to reconcile with Street’s FY19E 20%+ earnings growth at the beginning of the year. Anything other than a very solid revival on the top line cannot support such expectations.

F3Q (Dec) earnings for Nifty Midcap 50 (ex-financials) meanwhile grew at a healthier ~23.5% in F3Q (Dec), but headline was skewed by a handful of names (half of that growth was attributable to 3 of the top 8 components).

We had been stressing upon risks of earnings cuts within mass consumption categories such as two-wheelers and telecom services. Consider F3Q results of Nifty’s two 2W components, Bajaj Auto and Hero Motocorp, both of which were fairly hit in the post-demonetization period. While the Street was rightly not baking incremental margin expansion in these names for FY19E (Mar), margin contraction risks were largely ignored. As the year began, FY19E (Mar) consensus revenue growth for these names was in the low-teens, a bit higher than what these names averaged in Dec quarter when comping the low base from last year.

Meanwhile, their FY19E earnings were being forecasted to grow in the 10 to 15 percent range, a sharp acceleration from the 4 percent average growth in this past quarter, even as materials costs are clear headwinds going forward. Similarly, Bharti Airtel’s FY19E was built on high single-digit growth in revenues amid continued ARPU pressures. All said, based on F3Q (Dec) earnings, approximately two thrds of Nifty’s components (ex-financials) need to show material acceleration in earnings growth to come in line with street’s FY19E expectations, as at the beginning of the year (see Exhibit).

As we write this, if you are forced into an F3Q (Dec) reading from the viewpoint of FY19E, you should be more concerned than reassured. While India’s earnings growth isn’t shabby in relative terms, stocks certainly aren’t priced for such numbers. As majority of investors continue to feed on an increasingly sanguine top-down narrative, you would be well served to check gas levels on the dashboard.

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house